Financial crisis of 2007-2008 has shown that regulations imposed on the banking system are not effective enough to prevent banks from taking large systemic risks. Although new Basel II requirements for credit institutions significantly changed banks’ supervisory legislation in 2004, bank's governors did not take into account appearance of fundamentally new products such as mortgage-backed securities, collateralized debt obligations (CDO), and credit default swaps (CDS).
This paper discusses several questions related to the process of securitization and recent financial crisis. The main purpose of the proposal is to define the shortcomings in current banking regulation system and Basel II principles, which have been the most significant for the recent financial crisis. The paper presents some suggestions for the improvement of regulatory requirements for financial institutions in proposal’s conclusive part.
Research Questions and Literature Review
This proposal refers to four main questions related to financial crisis and banking regulations. First of all, the securitization process is described, and its useful properties as well as risks are outlined. Short definitions for the main securitized banking products are presented and discussed in the frame of basic features, distinctions, and significance for the financial market. Next, the financial crisis 2007-2008 is analyzed along with its causes and consequences for the banking system. The third question is related to the existing risk-based regulatory system (mainly, the requirements of Basel II) applied for banking and non-banking financial institutions. Finally, the paper critically reviews the shortcomings in current banking regulations and analyzes the failure of Basel II principles to prevent the financial crisis. The paper also shows the ways of possible adjustments to the regulatory framework, which can assist to avoid similar critical situation in the future.
The proposal relies primarily on published analytical articles, internet materials and author’s opinion on the research problem. The works of the following researchers were used for the analysis of the financial crisis and banking regulation shortcomings in the proposal: Stimson (2006), Hellwig (2008), Jobst (2008), Gorton & Metrick (2011). Definitions of the securitized banking products are taken from the internet dictionary Investopedia US (2013).
As defined by Investopedia (2013), securitization process occurs when an issuer (a bank or other financial institution) “creates a financial instrument by combining other financial assets” and sells it partly as “different tiers of the repackaged instruments” to the investors. Usually, non-liquid assets, which do not bear any interest income, are pooled and repackaged into interest-bearing and liquid securities. Securitization idea appeared in 1970 when the US Government-backed institutions combined home mortgages and issued securities, which transferred principal and interest payments from home buyers to investors (Jobst 2008).
Later, banks started to securitize other assets, which produced higher income, but imposed higher risks. The most notorious example is securitization of subprime mortgages, which has led to current financial crisis.
As growing number of banks and non-banking financial institutions transferred their credit risks into securitized products, the financial market became more complex and unstable. Such products as CDO and CDS have appeared in the market and became so complicated that very few investors could adequately assess their risks.
Collateralized Debt Obligations (CDOs) are defined as “investment-grade securit[ies] backed by a pool of bonds, loans and other assets” (Investopedia 2013). CDOs can include different types of credit risks (debts). They are constructed as “tranches” of risk levels (from AAA or A++ grade downwards), which are associated with respective maturities, risks, and returns. The complexity of the securitized portfolio affects the accurate evaluation of CDOs’ prices as well of the graded tranche returns. Therefore, there is always a chance to speculate on CDOs in the market.
Another type of the securitized product is the credit default swap (CDS). It can be characterized as “a credit derivative contract” that obliges the purchaser of a swap to make payments to the seller of a swap “until the maturity date of a contract” (Investopedia 2013). At the same time, the seller of a swap pays off total amount of third party’s debt in case of a default. Such swap is a type of guarantee (or insurance) for the swap purchaser. Still, CDS also provides an opportunity for both parties to speculate on the probability of default of the third party.
Securitized products are highly useful for financial market as they bring liquidity and generate higher returns on non-liquid assets. Besides, they are constructed in a way to ensure safety and guarantee payments to the investors and issuers. However, as the structure of modern securitized products becomes more and more intricate, evaluation of these assets often differs from the true assessment and provides opportunities to speculate. As economic history shows, any speculation opportunity is always too risky for market stability and can result in financial crisis.
Causes of the 2007-2008 financial crisis
As it was published in the Global Financial Stability Report of the International Monetary Fund (IMF) in October 2008, the total amount of “losses on non-prime mortgage-backed securities in US residential real-estate” constituted around 500 billion dollars (Hellwig 2008). At the same time, the total volume of securitized assets was evaluated at about 1.1 trillion dollars while real-estate prices in the US market declined on average by 19 per cent from summer 2006 to the year 2008. The level of risk exposure and fluctuations of base assets have brought financial crisis that impacted most of world’s developed countries and markets.
Financial crisis of 2007-2008 was caused by a range of the following interrelated factors:
- Speculations on the market due to the incorrect evaluation of securitized portfolios.
- Growing complexity of the traded securitization instruments.
- Deterioration of credit portfolios included in securitized products and real estate price fluctuations.
- Systematics and similarity of the risks taken by most of the investors.
- Outdated regulations of the banking system.
As discussed in the previous section, the opportunity to speculate on securitized products has occurred primarily due to the risky composition of the portfolios included into traded instruments (CDOs and CDS). Securitized portfolios included highly diversified types of loans that differed in risk levels, types of borrowers, and objects of loan agreements. This gave the impossibility to evaluate such instruments correctly and brought the speculation opportunity to the market. More informed investors or issuers could speculate on prices and returns due to differences in loan maturities and risks borne.
Increasing complexity of securitization instruments themselves also worsened the situation in the market. CDOs, CDS, and other securitizations were divided into trances assessed by different rating grades and traded separately at respective prices. A line of intermediate parties between the initial borrower and the final investor has become so vague that it has been virtually impossible to track all participating actors.
In its origin, securitization is meant to provide more stability and assurance to the players of the financial market. Relying on that, banks and other financial institutions found a chance to lower down credit standards for loan acceptance and started lending to subprime borrowers. Besides, mortgage loans are self-insured by the real estate bought with the loan by the borrower. As market for real estate is considered to be illiquid and, thus, not risky with no or small price fluctuations, mortgage loans have been related to as low-risk portfolios as well. The critical situation occurred when subprime borrowers realized inability to pay loans back and started to sell houses. This resulted in a strong pressure on the market supply and moved real estate prices down, which was not expected by lenders.
With all the factors stated above, financial crisis would never occur if the situation was not a systemic one. The whole financial market of the USA and other developed countries was put into crisis while almost every banking and non-banking financial institution appeared to be involved in securitization, speculations, and real-estate exposure. Current financial crisis can be compared to the 19th century banking panics, which caused a crash in the financial system only due to its systematics. As described by Gorton & Metrick (2011), “depositors en masse” decided to go to “their banks seeking to withdraw cash in exchange for demand and savings deposits”.
The final reason of the financial crisis was related to the regulatory system of financial institutions (Committee on Oversight and Government Reform 2010). Obviously, regulations should have been adopted to control the growing securitization activities of banks and non-banking financial market players. There have not been any significant changes to capital requirements or information disclosure related to securitized portfolios. This allowed some market players to be more informed than the others were.
Current risk-based regulatory framework and its shortcomings
Financial institutions are regulated primarily by the Sarbanes-Oxley Act and Basel II capital requirements. The first one is a general document regulating obligatory information disclosure for companies and organizations of all types. The second one is related to financial institutions, their solvency, capital adequacy, and credit position.
The Sarbanes-Oxley Act (SOX) was accepted in 2002 and considerably toughened the requirements to financial reports and process of their preparation (Sarbanes-Oxley Act 2002). Since July, 2005 Sarbanes-Oxley Act is applied to all (including non-American) companies that are presented on American securities market. Application of Sarbanes-Oxley Act is most necessary in defining the structure and transparency of internal reporting, requirement of composing periodic reports by banks’ management, defining the terms and qualitative characteristics of internal reporting, and arranging managerial accounting. However, this document needs to be seriously revised for financial institutions, which need to disclose more information on securitized portfolios and investments in securitized instruments.
Basel II regulations were accepted in 2004 and published as the “International Convergence of Capital Measurement and Capital Standards: a Revised Framework (Basel II)”. The Basel II imposed regulations on financial institutions summarized the objectives of bank governors as three “Pilars” (Deutsche Bundesbank 2004).
Pilar 1 is related to minimum quantitative requirements to owners’ capital volume. To assess the adequate capital volume, financial institutions should use the standardized approach and apply risk weights to respective exposures in accordance with external evaluations of assets (provided by recognized assessors such rating agencies). This requirement did not consider that assessing companies (credit rating agencies) also need to be regulated. Besides, an opportunity should have been left for a financial institution to assess the exposure at a different risk level if there is additional information available on an asset.
Pillar 2 and Pillar require qualitative review of financial institution’s risk position by high-level supervisory bodies. Under this requirement, financial institutions have to disclose more information to their supervisors. However, there is no special requirement to disclose relevant information publicly, especially on securitizations conducted by the financial institution and its investments into securitized portfolios.
Financial crisis has shown that the regulatory system of financial institutions lacks flexibility and does not account for the complexity of new banking products. The requirements of Sarbanes-Oxley Act and Basel II should be adjusted to include necessary requirements to securitized portfolios and other unordinary investments of banks. New regulations need “to be laws, not standards” (Stimson 2006). Financial institutions’ management of credit risk exposures and capital adequacy has to be more disclosed to investors and give a strong base to evaluate complex products more accurately. Besides, regulations need to include rules for preventing systemic risks of financial institutions and taking too high exposure to one type of financial instruments.